Why and How to Pick Tactical for your Portfolio

This note seeks to make two points about why and how to pick a tactical manager. Section 1 shows that Tactical can provide better returns and better risk-adjusted returns than a static allocation to asset class buckets. Section 2 shows that within tactical, picking a diversified portfolio of managers is vital to achieving Tactical’s promise.

Tactical asset allocation strategies have grown steadily over the past decade to become the majority investing style. To be sure, 13 out of the largest 25 funds in Morningstar’s ETF Landscape summary report Q3 2013 identify as tactical. Out of 178 managers surveyed by the Greenwich Associates US Exchange Traded Funds study in 2013, 72.4% employed tactical adjustments using ETFs.

What has made Tactical so popular? In secular bull markets such as the one in the 90s, a buy and hold strategy was acceptable. But diversification within the style/size boxes hasn’t protected funds from a market collapse, especially if all asset classes became highly correlated during those episodes.

The Tactical Strategies’ Index, shown in the Chart below, is a current AUM-weighted index of 29 tactical funds (with AUM greater than $100 million) using Morningstar data. As seen in Chart 1, tactical strategies as an aggregate group have consistently outperformed the S&P 500, 60/40 portfolio and HFRI Hedge Funds’ Composite both historically and more recently.

Adding the average tactical manager to a static portfolio has improved returns, reduced volatility and brought down drawdowns as tactical strategies search among the asset classes for better alpha without charging hedge funds’ fees.

To illustrate, we added a 20% average tactical strategy to static 60/40 portfolio. As shown in the chart 5, $1000 invested in a 50% S&P 500, 30% AGG and 20% tactical portfolio in Jan 1996 would have generated $4300 today and only $3270 in a 60/40 portfolio. Adding even a small exposure to tactical in an index-following passive portfolio has significantly improved returns while bringing down the overall portfolio risks as demonstrated by the performance of a 50% stocks/30% bonds/20% tactical portfolio versus 60% stocks/40% bonds.

In the following section, we discuss strategies for exposure to the tactical space. In our research, we find that investing a portfolio of tactical managers is a better investment strategy for adding tactical than using a single manager.

Tactical ETF managers are not substitutable

The performance of tactical ETF managers is much less correlated than that of traditional passive and even of active mutual fund managers. The average pairwise correlation of the 15 biggest large-cap mutual funds is high at 0.93. Compared to that, the largest 15 tactical managers show a much lower mean correlation of 0.55. This heterogeneity illustrates the benefits of diversifying with and diversifying amongst the tactical managers themselves.

To quantify the benefits of diversification at the manager level, we ran a simulation where we compared the performance of a randomly selected diversified portfolio of 3 managers with a single manager. Chart 4 shows the simulation results: the bars represent the distribution of excess risk-adjusted return of a portfolio of 3 tactical managers over a single tactical manager. For 70.5% of the iterations, the portfolio had a higher Sharpe ratio than a single manager.

Not only does picking more than a single tactical manager add diversification benefits, it also reduces the pressure of correctly guessing who the next period’s best performing tactical manager will be. The more diversified the portfolio is and the less correlated the managers are, the more likely it outperforms a randomly selected manager.

Summary:

Tactical, as an investment approach, has evolved from the fixed asset-class silos into a multi-asset ‘go-anywhere’ approach that has shown better risk-adjusted performance and lower drawdowns especially during market downturns.

Adding a small exposure to tactical has significantly improved returns while bringing down the overall portfolio risks as demonstrated by the performance of a 50% stocks/30% bonds/20% tactical portfolio versus 60% stocks/40% bonds.

Due to the heterogeneity among tactical strategies, there are diversification benefits from investing in a portfolio of tactical managers instead of using a single manager in order to get exposure to Tactical.

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All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.